What are Conversion Costs?

Definition: A conversion cost is the amount incurred during the transformation of raw materials inventory into finished goods. In other words, this is the amount of direct labor and overhead costs that are required to turn raw materials into an actual product.

What Does Conversion Cost Mean?

Conversion costs consist of both overhead costs and direct labor. Overhead costs are expenses used to produce products that can’t be attributed directly to a production process. Take utilities for example. Factories must use electricity to power their machines and produce products, but each dollar of electrical costs can’t be directly tied back to the products that were produced. They must be allocated and estimated.

Direct labor is the cost associated with workers who actively produce products. This includes the wages and salaries paid to assembly line workers, machinists, painters, and anyone who helps the manufacture products.

The true cost a company uses in the process of turning raw materials into finished goodsincludes both overhead and direct labor. Managerial accountants and production managers measure these conversion costs to estimate production expenses, develop product-pricing models, and estimate the value of finished inventory. Managers also use these costs to evaluate the efficiency of the production process and identify waste.

Example

Bruce’s Bike Company is a bicycle manufacturer that specializes in high-end 10-speed bikes. Bruce is trying to figure out what his conversion costs are for the quarter in order to estimate his finished inventory for the interim financial statements. Bruce identifies the following expenses totaling $50,000.

Factory Employee Wages

Equipment depreciation

Equipment maintenance

Rent

Supplies

Insurance

Bruce also had raw materials totaling $15,000.

Bruce’s total conversion costs equal $50,000. The raw materials are considered direct material costs and are not included in conversion costs. Instead, these expenses are included in another category of production costs called prime costs.